State Finance

California May Resort to IOUs

What's an IOU worth from the nation's most financially troubled state? Thousands of California businesses, nonprofits, and local governments are about to find out.
The Golden State is supposed to finalize its 2009-10 fiscal budget by June 30, but the state's Democrat-controlled legislature and Republican governor are at odds over how to plug a $23 billion funding gap. A plan passed on June 28 in the State Assembly would result in sharp hikes in taxes and fees as well as cuts in government spending. Governor Arnold Schwarzenegger has said he's in favor of more structural changes, such as reducing the pension plans of future state employees.
The State Assembly's current budget plan calls for increases in vehicle registration fees, cigarette taxes, and a 10% tax on oil production in the state. "I will veto any bill that punishes taxpayers for Sacramento's failure to live within its means," the Governor declared on June 29. "It's time for the legislature to send me a budget that solves our entire deficit without raising taxes."
Absent a last-minute resolution of the budget stalemate, State Controller John Chiang says that starting on July 2 he'll begin issuing IOUs to thousands of recipients of state funding—everyone from college students to landscapers who work at government facilities. The so-called registered warrants will be promises that the state will pay the money back as soon as it has the cash. The state projects that will happen by October, even though Chiang says California faces a $3 billion cash shortfall in July that will jump to $6.5 billion by September. "Unfortunately, the state's inability to balance its checkbook will now mean shortchanging taxpayers, local governments, and small businesses," Chiang said.
those who need help most will sufferThis would be only the second time since the Great Depression that the state has had to issue IOUs to state contractors. Similar notes were issued during a budget impasse in 1992. In February, Chiang's office delayed payments of state tax refunds to ease a midyear budget crunch. A compromise plan of tax hikes and spending cuts allowed the state to keep going, and those owed refunds were paid within a couple of weeks.
California's finances have taken a hard hit in the recession because of falling income, and sales taxes. As usual, it's the folks who need help the most who'll suffer. According to the controller's Web site, the largest number of IOUs will likely go out to counties that provide assistance to the aged ($590 million), people out of work ($495 million), and the developmentally disabled ($363 million).
Jean Hurst, a lobbyist for the California State Association of Counties, says county governments are talking to banks and other lenders, who may agree to cash the IOUs in exchange for the interest the state promises to pay on the notes. "That will be key to our survival," Hurst says. "We're seriously concerned about the cash-flow situation at the local level. We don't have the funds to float the state."
The State's Pooled Money Investment Board, which invests the state's short-term funds, will set the rate for the warrants at an emergency meeting on July 2. But even the promise of interest on the money is a problem for businesses that will likely be paid much less than what it costs them to borrow money."We could be losing money just from a financing perspective," says John Riley, operations manager at Sacramento Technology Group, which provides high-tech products and services to the state.
a secondary market in IOUs?Jonathan Brown, executive director of the Association of Independent California Colleges & Universities, says his 75-member colleges will likely receive IOUs for tuition reimbursement under a state program called Cal Grants. He says the schools will keep students enrolled and hang on to the warrants until they can be redeemed. The cash crunch is likely to be severe at state universities that receive much more of their funding from Sacramento, he says. Many have already had to cut staff and eliminate programs because of the state's budget woes. "It's causing them some real heartburn," Brown says.
Merle Thompsen, a landscaping contractor in Reseda, Calif., says he now considers himself fortunate that he didn't win any bids recently to provide services at state facilities. Thompsen says he remembers the last time the state issued IOUs, contractors were given the option of continuing to work or halting projects. Stopping the work is usually more complicated, requiring contractors to stabilize the site before they leave. "That costs the state more money," he says. "It's almost easier to keep working."
Thompsen says he also remembers a secondary market developing where independent financial firms offered to cash in the IOUs for a fee of anywhere from 6% to 20% of the note's value. "It's expensive," he says.
California's budget woes have frequently put State Controller Chiang, a first-term Democrat who had previously kept a low profile, at odds with the well-known governor. Just how tense things have gotten can be seen on the list of commonly asked questions about the IOU program on the controller's Web site. Question No. 24 is: "Who can I call to complain about this?" The answer: The governor's telephone number is (916) 445-2841.

Palmeri is a reporter for Bloomberg News and Bloomberg Businessweek in Los Angeles.